As a group, I don’t think we’ve given the correlation between the dollar and stocks the attention it deserves. However, since Daniel from Brazil has posted a chart of the dollar with comments, I thought I would jump in with a couple observations. The rally off the market bottom was fueled by central banks pouring liquidity into economies with the hope of averting a fiscal meltdown. The US took the lead, pouring billions of dollars into the markets. As the Treasury poured, each dollar got cheaper.

Consequently, as the dollar dropped in value, investments with a higher level of risk–commodities, stocks, gold, etc, went up. Astute traders, like Goldman Sachs, figured out that shorting the dollar and going long risk was blissful, and they and others piled in, creating the “carry” trade–short the dollar, go long commodities, stocks, etc. There are now so many folks, and so much paper profits in this trade that the correlation between the dollar and the S&P has reached an extreme, seeming to move inversely tick by tick. The Forex guys goose the dollar, stocks sell off; they take profits, the dollar falls and stocks rally. You can see this correlation in the comparison chart. It shows two ETFs–UUP (long dollar) and the SPY (long S&P) and the inverse comparison is remarkable.

While at the moment it looks like the dollar and the S&P are drawing together (perhaps seeking value as Alex often points out), I find myself wondering how and when this enormous bubble of a carry trade gets resolved. Like all bubbles, once it blows a lot of people are going to lose, and a tiny few will profit. I prefer to be in the latter group instead of the former. If this carry trade does unwind with a jolt, the dollar will soar as the shorts cover, and the S&P will plunge. If this happens, I’ll be short the indexes via the inverse ETFs.

Until this intense inverse correlation between the dollar and the S&P resolves itself, I’ve pretty much given up on individual stocks. I find it simpler and safer to trade the index ETFs, mostly SPY, SSO and SDS, and some of the foreign country funds like EWZ. Though they are very thin, I’m also trying small bets in the currency ETFs, like ULE and EUO. I plan to trade for many more years, and even though this volatility is exciting and compelling, I’ve cut my trade size back and watch drawdowns like a hawk. Remember, the Forex markets are traded around the clock and morning gaps in either direction can be brutal. To compensate, I’m buying weakness on the close, selling quickly into strength and using tight stops.